Tuesday, January 6, 2015

Deflation and the year ahead

Stocks
were hit by selling pressure on Monday as the S&P 500 (SPX) declined 1.83%
and the Dow 30 shed 1.86%. The energy
sector bore the brunt of the selling with the NYSE Oil Index declining 4.61%. Crude oil prices also dropped nearly 5% for
the day to close at 5 ½-year lows.

Fears
that Greece may exit the euro zone are being blamed on the latest broad market
decline. Upcoming elections in Greece
have spooked many investors, who feel that the country’s exit from the euro
zone would be disastrous. The most
likely reason for the market decline, however, is the fact that investor
sentiment has been excessively bullish in the last couple of weeks. A pullback in the major indices should remove
much of the excess optimism and pave the way for a sounder market
environment.

Many
investors are also concerned over the potential for a bad year based on the
so-called January Barometer. This
indicator is predicated on the belief that as goes the month of January, so
goes the entire year. Some even place
emphasis on the first five days of January as having prognosticative
value. Yet the January Barometer was
wrong in 2014 – the month of January last year was resoundingly negative, yet
the year as a whole was positive.

As
discussed in previous commentaries, the year ahead should be a bullish one
overall based on the Year Five Phenomenon, notwithstanding the possibility of a
volatile January. This particular market
maxim has held true for over 100 years, namely that there has never been a
losing year in the fifth year of the decade.
The reason for this is that the 10-year Kress cycle bottoms at the end
of the fourth year and the resultant upward pressure from the new-born 10-year
cycle is beneficial for equity prices.

Turning
our attention to the crude oil collapse, weakness was once again in the oil
price on Monday. The crude oil price was
3% lower for the day after hitting a 5 ½-year low. Adding to pressure against crude oil prices
has been persistent strength in the U.S. dollar index (see chart below). Recent dollar strength and oil price weakness
has once again stirred up concerns among investors that deflation could be a
problem in 2015.

While
I don’t envision deflation being a dominant theme for most of 2015, it could be
problematic during the early part of the year.
When the 60-year Kress cycle of inflation/deflation entered its final
“hard down” phase in 2008 it created major problems for the U.S. financial
sector in 2008-2009. Yet except for a
brief period in 2008 and early 2009, it failed to deliver the anticipated
deflationary collapse in essential commodity prices and the corresponding
increase in the dollar’s value. Many
investors jumped to the conclusion that the long-term Kress cycle was either
broken or else mitigated by the monetary policy actions of the Federal
Reserve.

Bud Kress always used to say
that ultimately “Mother Nature and Father Time” would prevail when it came to
the financial market. That is, the
natural forces of inflation and deflation will always manifest sooner or later
– even when central bankers do their utmost to stifle it. Viewed from this standpoint, the recent oil
price collapse, dollar rally and overseas turbulence can be attributed to the
cycle somewhat belatedly having its way despite the efforts of central
banks. Central bankers thought they could completely eliminate the impact
of the cycle but it would seem that the cycles are having the last laugh.

On the subject of the oil
price collapse, a recent Bloomberg article entitled “Oil below $60 tests U.S.
drive for energy independence” provided some background for the ongoing
crisis. Asjylyn Loder, who wrote the
article, observed: “The U.S. shale boom that’s brought the country closer to
energy self-sufficiency than at any time since the 1980s will be challenged in
2015 as never before.”

The article also pointed out
that some of the largest U.S. shale drillers “have been spending money faster
than they make it, borrowing to pay for their expansion.” It would appear then that the fracking boom
which provided a much needed stimulus to the U.S. economy at a time when it was
needed most will face its first major obstacle in the coming year. The oil price collapse and dollar rally has been
a boon for consumers – Goldman Sachs analysts have said that cheaper U.S.
gasoline will boost economic growth by 0.5 percentage points this year. Economist Mark Zandi of Moody Analytics
estimates that if oil prices stay at $60/barrel it will result in $150 billion
in savings on gasoline for consumers.

However, the oil price
collapse will also eventually run headlong against the old market bromide that
“low prices cure low prices.”